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What are International Derivatives?

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  • Written By: Ron Davis
  • Edited By: Allegra J. Lingo
  • Last Modified Date: 29 November 2016
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International derivatives are financial instruments traded across national borders. A derivative is an object whose price is inextricably linked to the price of another object, usually a commodity or a security. Most derivatives have been available to the international community for decades, but the widespread use of the Internet for trading has made international derivatives truly international.

The most widespread modern derivatives are futures on commodities and the options on those futures. Futures contracts are derivatives because their price is tied to the price of the underlying commodity, whether it is grain, crude oil, or one of the 30 other products that are actively traded. Futures are considered international derivatives because price is affected by global factors. For example, severe drought in the wheat fields of Russia will send the price of wheat futures soaring in Chicago, London or Shanghai, and war in the Middle East sends the price of crude oil and futures on crude oil sharply higher around the world.

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Commodities futures are the oldest derivatives. The Chicago Board of Trade (CBOT) was formed in 1848 for the purpose of trading grains and contracts on grains. Those contracts were soon standardized with respect to the amount of grain in each contract, the quality of the grain, the point of delivery for the grain, and the month and day of delivery. All that remained for the buyers and sellers to negotiate was price. In a ground-breaking move, the CBOT made the bids, offers and negotiated prices available to the public.

By the early 20th century, butter, eggs, hogs and cattle were all traded as futures on the Chicago Mercantile Exchange (CME). In 1971, the currencies of the world were officially de-linked from gold, and the CME established futures on currencies, the first intrinsically international derivatives. Futures now include electricity,weather, precious metal, petroleum, financial, and many others, and are traded world wide on the Internet. The transparency of price discovery, the knowledge of how many contracts are outstanding at any given time, and the ability of regulators to trace transactions to prevent fraud or rules violations has created a market for international derivatives in which the world is willing to participate.

The collateralized debt offerings (CDOs) created by banking and insurance giants of the late 20th and early 21st century are also international derivatives. Unlike the public markets, these markets were unregulated and poorly documented. No banker knew how large the market was, what fraction of the nominal value was represented by actual collateral, or whether the counter-party to a trade would be able to perform, should he be called upon in case of emergency. The CDO market, opaque, unregulated, and without a central clearing house like those that provided success for the regulated international derivatives, collapsed quickly with potentially catastrophic results for the economies of the world.

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